Valuing Interests in S-Corps Michael Gregory Michael Gregory Consulting LLC for 2013 Federal Tax Institute Little Rock, Arkansas December 6, 2013

Valuing Interests in S-Corps Michael Gregory Michael Gregory Consulting LLC for 2013 Federal Tax Institute Little Rock, Arkansas December 6, 2013 Presenter Michael Gregory, Chief Manager, Michael Gregory Consulting LLC since September 12, 2011 Formerly IRS 28 Years as Engineer and Valuer, Manager, Operations Team Lead, Controller, Acting Assistant District Director, Territory Manager ASA, CVA, MBA and Mediator MN Supreme Court www.mikegreg.com 2 Michael Gregory Consulting LLC Developing Leaders Risk Management with the IRS Valuation Report Reviews www.mikegreg.com mg@mikegreg.com 651-633-5311 ManagingResolutions.org How to Work with the IRS: Strategies for Attorneys, Accountants, and Appraisers (June 2012), Business Appraisals and the IRS(May 2013),Valuing Interests in S-Corps (July 2013), Discount for Lack of Marketability and the IRS(September 2013), The Servant Manager (November 2013) www.mikegreg.com 3 1

Disclaimer The opinions presented here are those of Michael Gregory. Michael Gregory does not represent the IRS. Any opinions presented in this seminar are those of the author and do not represent an official position of their current or previous employers. This material is offered for educational purposes only. The author and his employer expressly disclaim any liability, including incidental or consequential damages, arising from the use of this material or any errors or omissions that may be contained in it. www.mikegreg.com 4 Introduction to Today s Presentation 1120S Corporations Background Court Cases Summarized Valuation Approaches Used Personal Observations www.mikegreg.com 5 1120S Corporations Background What Is an 1120S Corporation and Why Was it Invented? What Are the Benefits of the S election? What Are the Disadvantages of the S election? Additional Considerations www.mikegreg.com 6 2

1120 S Corporation S Corporations elect to pass corporate income, losses, deductions and credits through to their shareholders for federal tax purposes. Shareholders pay taxes once based on individual rates. S corporation shareholders avoid double taxation on the corporate income. S corporations are responsible for tax on certain built-in gains and passive income. Today more S than C corporations at 66% according to IRS data www.mikegreg.com 7 Requirements to be an S Corp Be a Domestic Corporation Have Only Allowable Shareholders Including Individuals, certain trusts, and estates, and May Not Include Partnerships, Corporations, or Non- Resident Alien Shareholders Have No More Than 100 Shareholders Have One Class of Stock Not Be An Ineligible Corp, i.e. Certain Financial, Insurance or DISC s Submit Form 2553 Signed by All Shareholders www.mikegreg.com 8 Background Internal Revenue Code 1361 to 1379 Added in 1956 Modified in 1982 Purpose Was to Allow Small Enterprises Advantages Allowed Corporate Form without Tax of C Corp Disadvantage www.mikegreg.com 9 3

Advantages of S-Corps No Double Taxation No Double Taxation. S-Corp Income Flows Through Pro-rata to the S-Corp Shareholders on Income and Losses FICA and Medicare on Taxes on Wages Only Taxed at their Individual Tax Rates. S-Corp is a Conduit Normally Not Subject to Tax. www.mikegreg.com 10 Advantages of S Corp In contrast, C-Corp Pays Corporate Income Tax Recipient of dividends from C-Corp pays taxes. Limited Liability Advantage for a Startup Company Allows immediate Use of Losses by Shareholder. C-Corp Losses Must Wait for Positive Income to be Used. www.mikegreg.com 11 Advantages of S-Corps Continued Possible Business Valuation Issue Note: For Tax Years After 12/31/2004, Up to Six Generations of Family Members Treated as One Shareholder. Note: Differences Among Voting Rights Does Not by Itself Create More than One Class of Stock. Also, Disproportionate Distributions Do Not Automatically Create More Than One Class of Stock. Simple Structure www.mikegreg.com 12 4

Advantages of an S Corp Build Up in Basis Positive S-Corp Income Not Distributed Serves to Increase Basis. This Can Decrease Capital Gains Taxes Upon Sale. In Contrast, the Basis in C-Corp Shares Does Not Build-Up. Example: You Buy Shares of IBM for $150 Per Share IBM Has Income of $2 Per Share. Your Basis Does Not Increase by $2 to $152, It Remains $150 Capital Gain/Loss Based Upon the $150 Per Share You Paid. www.mikegreg.com 13 Disadvantage of an S Corp Restrictive Capital Structure Limiting Access to Debt; Shareholder s Risk Associated with Personal Tax Payments on Income at the Corporate Level; Limit on Type, and Number, of Owners; and Restrictions on Entity Structure. www.mikegreg.com 14 Additional Considerations Changes in Federal Tax Law; Changes in Laws Concerning S Corporations; Minority Versus Controlling Interests Marketplace for the Interest www.mikegreg.com 15 5

Converting from a C to S Corp Disadvantages of S Corps No Partnership Shareholders (Except for Single Member LLC Shareholders) Only Certain Trusts May be Shareholders Grantor Trusts Voting Trusts Testamentary Trusts (2 Year Limit) Electing Small Business Trusts (ESBT s) Qualified Subchapter S Trusts (QSST s) www.mikegreg.com 16 Converting a C to an S: Built in Gains Tax BIG TAX S Corporation is subject to BIG tax at the highest C Corporation tax rate (currently 35%) based on the difference between the fair market valueof the corporations' net assetsover the adjusted basis of the net assetsas of the first day of the first year the S election becomes effective. www.mikegreg.com 17 Converting from C to an S BIG TAX The tax apples to dispositionsof assets in certain years following the conversion to S Corporation status: Years beginning in 2009 applies only to dispositions in first 7 years Years beginning before 2009 or after 2010 applies to dispositions in first 10 years www.mikegreg.com 18 6

BIG TAX The Internal Revenue Code has a presumption that any gains on disposition of assets during the 7-or 10-year recognition period is recognized as a built-in gain. Two ways of overcoming the presumption that all gains are recognized as built-in-gains: Asset sold or distributed was not held as of the effective date of the S status Gain had not been accrued as of effective date of the S status This is Where An Appraisal Enters the Picture www.mikegreg.com 19 What is Taxed "Net recognized built-in gains" which is defined as the lesser of: The amount that would be taxable income of the S Corporation for the taxable year if only recognizedbuilt-in gains and losses are taken into account, or the S Corporation's taxable income for that year (as specially calculated) More Issues Here Such As Accounts Receivable, Pre-Election on Installment Sales, Completed Contract Method Contractors, Inventories, Specific Assets, Etc. Don t Forget Intangibles www.mikegreg.com 20 S Corp Compensation Issues Potential S-Corp compensation issues are unlike C-Corps. Potential issue for S-Corps is undercompensation S-Corp under compensation is often seen due to employment taxes. Owner might rather extract money through distributions. Reference the following courts cases: Veterinary Surgical Consultants, P.C.vs. Commissioner, 117 T.C. 141 (2001), Jolyvs. Commissioner, 211 F.3d 1269 (6 th Cir., 2000), and Joseph M. Grey P.C.vs. Commissioner, 119 T.C. 121 (2002) Compensation issue could affect business value. www.mikegreg.com 21 7

When Are Appraisals Needed? First, Note An Appraisal for a Business, Machinery and Equipment, Real Estate, Etc. Whenever an existing C Corporation converts to an S Corporation Whenever an S Corporation acquires assets in a tax-free merger, etc. Whenever an S Corporation distributes property (other than cash) to a shareholder www.mikegreg.com 22 Court Cases Summarized Gross v. Commissioner, T.C. Memo 1999-254, 78 T.C.M. (CCH) 201, T.C.M. (RIA) 99,254, 1999 Tax Ct. Memo LEXIS 290 (July 29, 1999). Wall v. Commissioner, T.C. Memo 2001-75, 81 T.C.M. (CCH) 1425, 2001 Tax Ct. Memo LEXIS 97 (March 27, 2001); Estate of Heck v. Commissioner, T.C. Memo 2002-34, 83 T.C.M. (CCH) 1181, T.C.M. (RIA) 54,639, 2002 Tax Ct. LEXIS 38 (February 5, 2002); www.mikegreg.com 23 Court Cases Summarized Estate of Adams v. Commissioner ( Adams ), T.C. Memo 2002, 83 T.C.M. (CCH) 1421, T.C.M. (RIA) 54,696, 2002 Tax Ct. Memo LEXIS 84 (March 28, 2002) Robert Dallas v. Commissioner, TC Memo. 2006-212 2006 WL 2792684 (U.S. Tax Ct. Sept. 28, 2006) Estate of Louise Paxton Gallagher v. Commissioner,TCM 2011-148. www.mikegreg.com 24 8

Gross Result As a theoretical matter, we do not believe that tax-affecting an S- Corp s projected earnings is an appropriate measure to offset [the] potential burden associated with S-Corp s. Facts Gift valuation of minority shares Profitable soft drink bottler Restrictive agreements History of distributing earnings Government expert used 0% S tax, Estate s 2 experts applied 40% corporate tax www.mikegreg.com 25 Wall Result Because this methodology attributes no value to Demco s S corporation status, we believe it is likely to result in an undervaluation of Demco s stock. Facts Gift valuation of minority shares Profitable office supplies distributor and manufacturer Government appraiser applied 0% tax Taxpayer expert applied 34% corporate income tax www.mikegreg.com 26 Heck Result Court s model used only 1.5% CA tax Court conflated experts discounts into minority discount Facts Estate valuation of minority interest Profitable sparkling wine vintner Government expert applied 0% federal and 1.5% CA rate Also applied 10% discount Loss of S-Corp status and shareholder taxes Taxpayer expert applied 1.5% CA rate Also applied 10% discount Right of first refusal and other specific issues www.mikegreg.com 27 9

Adams Result Court rejected increasing discount rate for hypothetical S-Corp tax [I]t is appropriate to use a zero corporate tax rate to estimate net cash flow when the stock being valued is stock of an S corporation. Facts Estate valuation of 61.59% of voting common Profitable retail insurance agency Government expert applied 0% tax rate Taxpayer expert applied 0% rate, but Increased discount rate to adjust for hypothetical corporate tax www.mikegreg.com 28 Dallas Result Court did not accept tax applied to S-Corp Court rejected assumption that S-Corp would be lost Facts Sale of minority interests to trusts Cash plus notes deemed paid if seller died Profitable chemical manufacturer and distributor Taxpayer s two experts applied corporate tax rates One based on assumed loss of S-Corp status after sale One based on shareholder level income tax Taxpayer contended willing buyer would tax affect www.mikegreg.com 29 Gallagher Result Court Did Not Accept Tax Applied to S-Corp Court Applied Other Adjustments Facts Did Not WACC or CAPM Wanted Equity and Build Up Method Not Going Public Anytime Soon Assumptions Reviewed and Comments www.mikegreg.com 30 10

Court Cases Key Points Given Facts in Case and Information Before the Court the Court Decided not to Tax Affect 1120S Corporations Quote from Gallagher by Judge Halpren in Gallagher: Mr. May (Petitioner s expert) failed to explain his reasons for tax affecting PMG s earnings and discount rate and for employing two different tax rates (39 percent and 40 percent) in doing so. Absent an argument for tax affecting PMG s projected earnings and discount rate, we decline to do so. As we stated in Gross v. Commissioner, T.C. Memo. 1999-254, the principal benefit enjoyed by S corporation shareholders is the reduction in their total tax burden, a benefit that should be considered when valuing an S corporation. Mr. May has advanced no reason for ignoring such a benefit, and we will not impose an unjustified fictitious corporate tax rate burden on PMG s future earnings. www.mikegreg.com 31 Legal Issue vs. Factual Issue Background Legal Issue Perspective Factual Issue Perspective Study Team Perspective IRS Inconsistency Problem What Do You Do? Don t Tax Affect Tax Affect Using Models www.mikegreg.com 32 Leading Models Regarding Tax Affecting Instead of Tax Affecting Call It the Adjustment Associated with 1120S Corporations Models Considered Here Fannon Fannon Sellers Paper Grabowski Mercer Treharne Van Vleet www.mikegreg.com 33 11

Fannon Concept in Treharne Model Stopped Publishing in 2008 Followed Delaware Chancery MRI Radiology Associates IRS Looking for Litigating Vehicle No takers www.mikegreg.com 34 Fannon Sellers Paper Valuation of Pass Through Entities, Looking at the Bigger Picture Dec 2011 Presented at 2012 American Taxation Association Midyear Meeting Capitalization of S-Corps Should Have a Higher ERP How Much and Why? www.mikegreg.com 35 Grabowski Four Methods The Modified Traditional Method The Modified Gross Method The C-Corporation Equivalent Method The Pretax Discount Rate Method These Methods Provide Widely Varying Results Depending on Assumptions Key Assumptions Are: Cash Distributions; Expected Holding Period; and Most Importantly the Pool of Likely Buyers www.mikegreg.com 36 12

Mercer List of Six Assumptions Uses the QMDM Model to Value DLOM as S and C for Various Scenarios Mercer Asserts That the Level of Distributions Does Not Affect Value Important Factors Are: Length of Holding Period Extent of Expected Distributions Risk of Loss of Benefits www.mikegreg.com 37 Treharne Introduces Concept of a C-Corp Valuation Adjustment The Reinvestment of Retained Earnings May or May Not Contribute to Value Contribution of S Corp Because the Shareholder Avoids Paying the Double Taxation with C-Corp Dividends See A Hands-On Approach to S Corporation and Pass-Through Entity Valuations by Paul R. Hyde and Shawn M. Hyde, The Institute of Business Appraisers, Business Appraisal Practice, First Quarter 2010 Contact Me for a Workbook of the Spreadsheets www.mikegreg.com 38 Van Vleet S Corp Economic Adjustment Model (SEAM) Only Used for Non-Controlling Equity Interest in a S Corp Two Premises in the SEAM Model There Are Significant Differences Between the Income Tax Treatment of C and S Corps Capital Markets Are Efficient Over the Long Run This is a Mathematical Model That Needs Four Tax Rates and Dividend Payout Six Key Caveats Carefully Supported Reasoning and Analysis Are Needed www.mikegreg.com 39 13

Personal Observations Merle Erickson and Shiing-wuWang of the University of Chicago Differences in S vs. C, but less than Gross Case The Erickson and Wang study did show a small difference (approximately 12% to 17%) between sales of S-and C-corporations; however, the transactions in the study were, very large, drawn from the reporting of the acquisition of privately-held businesses by publicly-traded corporations. www.mikegreg.com 40 Personal Observations S Corps Are Rapidly Growing. Why? Effective Tax Rate on Corporations is 40% Wall St Journal Reported 69% of U.S. Corps as Nontaxable in 2008 Compared to 24% in 1986 3,500 of the Largest 4,500 Corporations Pay Less Than 5% Federal Income Tax The Average Operating Corporation Pays 13% Think About This in Terms of A Hypothetical Buyer and Seller What are the Facts in Your Case? www.mikegreg.com 41 Personal Observations Continued Look at Subject Look at Industry Look at Hypothetical Buyers and Sellers Tax Affect or Not to Tax Affect Consider Alternatives Consider Risks Make a Professional Determination www.mikegreg.com 42 14

Personal Recommendation Treharne Fannon Sellers Paper Reconcile Use at Federal and Local Levels www.mikegreg.com 43 Important Take Away Information if Working with the IRS Know Who Your Working with at the IRS Understand the Role of Participants Seek to Understand Interests Do Not Be Afraid to Ask Questions Consider Options Ask for a Valuer Ask to Elevate in Management as a Neutral Party Given Ownership of the Issue by the RA or ETA www.mikegreg.com 44 www.mikegreg.com www.mikegreg.com 45 15

How to Work with the IRS: Strategies for Attorneys, Accountants and Appraisers IRS Official and Unofficial Rules of Engagement IRS Organization My History and Best Practices Issue Resolution and Mediation at the IRS Classification in General and Estate and Gift in Particular Potential Penalties on Appraisers Reasonable Compensation in Corporations Discounts for Lack of Marketability Most Common Errors in Valuations Strategic Growth Areas of Business Valuation Appraisers Other Engineering Issues and Valuation Related Issues Strategic Thinking Overall Commentary and Do s and Don ts www.mikegreg.com 46 www.mikegreg.com www.mikegreg.com 47 Business Appraisers and the IRS 1. Overview of Chapter Contents 2. Classification in General and in Estate and Gift Tax in Particular 3. Writing a Business Valuation Report for IRS Tax Purposes 4. Potential Penalties on Appraisers 5. Considerations in Valuing Interests in Subchapter S Corporations 6. How to Address Reasonable Compensation in Corporations 7. Code Section 409A and Valuators 8. Discount for Lack of Marketability and How to Approach the Issue 9. Most Common Errors in Valuations and How to Avoid Them 10. Potential Growth Areas for Business Valuation Appraisers 11. How to Work with the IRS to Resolve Differences in Valuation 12. Key Take-Away Items for Business Valuation Appraisers www.mikegreg.com 48 16

www.mikegreg.com www.mikegreg.com 49 Valuing Interests in S-Corps From Chapter 5 in Business Appraisals and the IRS Pulled This Chapter from the Book Given Customer Feedback Covers the Material in This Presentation with 2 Example Comparisons Sixty Three Pages in Length www.mikegreg.com 50 www.mikegreg.com www.mikegreg.com 51 17

11/13/2013 Discount for Lack of Marketability and the IRS Uses the Discount for Lack of Marketability Job Aid for IRS Valuation Professionals Published August 2011 Supplemented With Commentary from Modelers Critiqued in the Original Job Aid Michael Gregory s Commentary Based on IRS and Private Sector Reviews of Scores of Reports for Expert Witnesses Specific Recommendations www.mikegreg.com 52 Michael Gregory Consulting, LLC mg@mikegreg.com www.mikegreg.com 651-633-5311 1945 Sharondale Ave. Roseville, MN 55113 Contact me with any questions or concerns www.mikegreg.com 53 What Are Your Thoughts and Questions www.mikegreg.com 54 18